Scientific Beta confirms the non-eligibility of China A-shares for its indices



Scientific Beta confirms the non-eligibility of China A-shares for its indices

Increasing the number of Chinese stocks in an investment universe dedicated to smart beta is not appropriate at this time

Scientific Beta, as a leading smart beta index provider, aims to build and publish equity indices that reflect the current state of the global economy while exhibiting a high level of liquidity, investability and replicability.

The definition and construction of an investable universe are key steps in the construction of every equity portfolio and in equity indexing. Investing in smart beta indices requires investors to have access to solutions where liquidity risk is thoroughly considered, because ultimately the weights of the stocks will not be equivalent to their cap-weighting but will depend on other weighting criteria.

This key driver is the main reason why Scientific Beta will not be adding China A-shares at this point, even if the Chinese authorities have made some progress on important aspects:

  • In December 2018, Chinese stock exchanges tightened their suspensions rules and conditions in an effort to reduce the number of suspensions.
  • In January 2019, the QFII quota doubled to USD 300bn to meet investment demand from overseas investors and prepare for the partial inclusion of China A-shares in some equity benchmarks.

Scientific Beta has noted these efforts made by the Chinese authorities to further promote the functioning of its stock market and enhance the overall market liquidity. Nevertheless, some accessibility issues, which Scientific Beta considers to be potential liquidity risks, or at least penalising for its clients, remain:

  • Chinese authorities could lock up foreign investor money in the case of extreme moves. Even with the recent liberalisation of QFII programmes, SAFE retains its power to exercise macro-prudential supervision over the repatriation of capital and may impose temporary restrictions.
  • Limited domestic availability of derivative instruments, in particular index futures, access to which is restricted to approved foreign institutional investors and remains limited in scope. This reduces investor ability to implement hedging strategies and risk management strategies.
  • Foreign-ownership restrictions on China A-shares, set at 30%, could become critical with future inflows. Indeed, buy orders via stock trading links with Hong Kong will be halted if foreign holdings reach 28%, creating liquidity issues. Buying will resume only when the figure falls to 26%.

Ultimately, the precautions taken by cap-weighted index providers, which are often adjustments to the capitalisation of the stocks in the indices, are of little use in protecting the liquidity of non-cap-weighted indices. As far as smart beta indices are concerned, this is why the rules applied to cap-weighted indices and their underlying universes are not appropriate and pose serious risks for investors. Scientific Beta is convinced that the current exposure offered to China through a dedicated Chinese geographic basic block made up of one hundred liquid constituents, which are H-Shares, P chips, Red chips and depositary receipts, all listed on foreign exchanges without trading restrictions, preserves investors from these unnecessary investment risks.

As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up Scientific Beta. Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
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